Copyright anbirts1 MSc In General Management FX and Interest Rate Risk Management

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MSc In General Management

FX and Interest Rate Risk Management

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Agenda 1 Foreign Exchange• Caveat, there will be some overlap!!• Exchange rate exposures - Translation - Economic - Transaction• Reading foreign exchange rates - Spot rates - Forward rates• Money markets

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• Agenda 2 Interest Rate Risk• Defining exposure• Measuring impact• Hedging instruments - Forward forward money - Futures - FRA’s - Interest rate swap - Option based instruments

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Why Manage Risk?

Objective of the Organisation

Maximise Shareholder Wealth

How? Cash Flow = Value

Discount Rate - Reduce Volatility - Reduce Risk - Reduce Cost of Capital

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Should We Manage Risk?

• Perfect Markets

• Parity

• Portfolio Theory

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Translation Exposure

Translation exposure represents the effects, as reflected in the balance sheet and/or profit and loss account, of a movement in exchange rates between reporting dates on the translation of assets and liabilities denominated in foreign currencies.

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Translation Exposure (In Millions)

ASSETS USD @ 1.20

GBP

@ 1.50

GBP

LIABILITIES USD @ 1.20

GBP

@ 1.50

GBP

Cash 15 12 10 Creditors due in one year

95 79 63

Investments 20 17 13 Creditors due over one year

6 5 4

Debtors 65 54 44 Provisions 1 1 1

Fixed Assets 20 17 13 Shareholder Funds

18 15 12

120 100 80 120 100 80

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Economic Exposure

The risk that, long term, the relative appreciation in real terms, of the currency in which a company’s major costs are denominated, will adversely affect that company’s competitive position.

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Economic Exposure: An Example CoAManufacturer in UK selling to France• Inflation rate 4% p.a.• Current Price GBP 100• Current Exchange Rate EUR/GBP.6503Competitor in France• Inflation Rate 2% p.a.• Current Price EUR 153.7752At Year EndIf PPP held• UK Price GBP 104 (100 x 1.04)• French Price EUR 156.85068 (153.7752 x 1.02)• Therefore Exchange Rate 104 = .6630509

156.85068But if rate has moved to EUR/GBP .6300 then UK Price of GBP 104 = EUR 165.08French price of EUR 156.85

Will they sell any goods?

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Transaction ExposureThe risk that arises from exchange rate changes reflected in the day to day trading activities of a company.

TRANSACTION EXPOSURE

EXAMPLE

Receipt due 180 days USD 1,000,000

GBP value @ current spot of 1.44

694,444

GBP value @ current spot of 1.50

666,666

LOSS 27,778


Approaches To Hedging

1. Foreign Exchange

– Spot

– Forwards

– Money Market Hedge

– Swaps

– Options (not covered today)


IllustrationsSpot

Situation: Receipt of USD 10,000,000 in two business days time

Spot Rate GBP/USD 1.6356 – 1.6366

Sell USD to Bank, Buy GBP

Rate 1.6366Receipt GBP 6,110,228.52


IllustrationForward

Situation: Receipt of USD 10,000,000 in 32 days time

Spot Rate GBP/USD 1.6356 – 1.6366

1 month Points 9 7

1 Month Forward Outright 1.6347 – 1.6359

Sell USD to Bank one month forward and Buy GBP rate 1.6359

Receipt GBP 6,112,843.08


Illustration: Money Market Hedge

Spot Rate

GBP/USD 1.6356 – 1.6366

1 Month Points 9 – 7

Forward Outright 1.6347 – 1.6359

Interest Rates

GBP 5 5/8 – 5 13/32

USD 4 31/32 - 4 27/32

Borrowing Spread ½%

Borrow USD @ 431/32 + ½ for 30 days = 5.46875%

Amount Borrowed 10,000,000 = 9,954,634

1 + (.0546875 x 30/360)

Spot USD 9,954,634 to GBP at 1.6366 = GBP 6,082,509

Invest GBP 6,082,509 at 5 13/32 (5.40625) = 6,082,509 x.0540625 x 30/365 = GBP 27,028 = Total GBP at Day 32 = 6,109,537

Situation: Receipt of USD 10,000,000 in 32 days time


Swaps


FX SWAP

• The Spot Purchase and Forward Sale

of Currency. The Two Transactions

are Executed

Simultaneously

and are based off the

Same Spot Rate


FX Swap Rates

• As with a forward contract the Bank will quote a spot and a forward rate for both sides of the market

• GBP/CAD 2.3378- 2.3403

1 Month Points 14 12


FX SWAP RATES

• However it is only the Forward Points representing the differential in interest rates between the two currencies that will affect the swap.

• The forward points to be used will be determined by the forward transaction in the Swap.

• The Same Spot Rate will be used for both the purchase and sale of the currency


EXAMPLE

• Your Canadian subsidiary tells you that it wishes to borrow Canadian dollars for one month (30 days). Their local bank will lend at 5.5% pa. Your GBP interest cost is 6% pa.

• Is it cheaper for the subsidiary to borrow from you or from the bank?


THE SWAP CALCULATION 1

Questions to ask 1 What will it cost in CAD? 2 In the Swap, what side will we be on in the forward? (this will determine the spot rate to use) 3 Therefore how many GBP do we need to borrow today to give CAD 3,000,000? 4 Therefore how many GBP will we have to pay back at 6.0% in the future? 5 At the forward rate, how many CAD will be needed? 6 Is this more or less than borrowing CAD directly?



• Borrowing CAD directly from the local bank will cost

• 3,000,000 x .055 x 30/365 = 13,561.64



Spot 2.3378 - 2.3403 30 Day Points 14 12 1 month forward outright 2.3364 - 2.3391

Today At spot of 2.3403Buy CAD 3,000,000.00 Sell GBP 1,281,886.94

1,281,886.94x.06x30/365 = 6,321.63Forward At forward of 2.3391Sell CAD 3,013,248.68 Buy GBP 1,288,208.57


ANSWER

• Borrow CAD Direct at 5.5%

Cost CAD 13,561.64

Borrow CAD via the swap

Cost CAD 13,248.68

So, on financial basis, do the swap

Effective interest rate in CAD

13,248.68 x 365/30 = 5.37%

3,000,000


USES OF THE SWAP

Can be used to• invest or borrow in a foreign currency for a specified period of time without creating an fx exposure• concentrate funds from a number of different currencies into one currency to obtain better rates without

creating an fx exposure• offset surplus funds in one currency against deficit in another

currency for a specified period of time without creating an fx exposure



• Agenda 2 Interest Rate Risk• Defining exposure• Measuring impact• Hedging instruments - Forward forward money - Futures - FRA’s - Interest rate swap - Option based instruments


Interest Rate RiskThe risk of loss of interest revenue that occurs when interest rates change, through the mismatch of re-pricing of assets and liabilities.

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0 1 2 3 4 5 6

Lend 6 Months at 5.5Fund Three months at 4.25

Time: Months

Inte

res

t R

ate

s P

A

Yield curve


Interest Rate Risk - Gap Analysis

(1) At 12% interest and 80% forecast op profit (2) at 10% interest and 80% forecast op profit

Months 0-6 6-12 12-18 18-24 24-30 30-36 36-42 42-48

Principal 9000 7875 6750 5625 4500 3375 2250 1125

i @ 8% 365 319 273 228 182 137 91 46

+ Principal 1490 1444 1398 1353 1307 1262 1216 1171

Op profit 1598 1597 1598 1597 1598 1598 1597 1598

I @ 10% 456 399 342 285 228 171 114 57

+ Principal 1581 1524 1467 1410 1353 1296 1239 1182

i @ 12% 547 479 411 342 273 205 137 68

+ Principal 1672 1604 1536 1467 1398 1330 1262 1193

Op profit 1598 1597 1598 1597 1598 1597 1598 1597

Short Fall (78) (7) 62 130 200 267 336 404

(1) Op Profit 1279 1278 1279 1278 1279 1278 1278 1278

Short Fall (393) (326) (257) (189) (119) (52) 16 86

(2) Op Profit

Short Fall (302) (246) (188) (132) (74) (18) 39 97


Interest Rate Risk

Instruments

• Forward Forward Money

• Futures

• Forward Rate Agreement

• Interest Rate Swap

• Interest Rate Options


Forward Forward MoneySituation: Need to borrow GBP 1,000,000 from 30 days time for 30 days

Current Interest Rate1 month 3-3½2 month 3¾-4Borrowing Spread ¼%Action: Borrow for 2 months at 4¼%, Deposit for 1 month at 3%

Borrow today GBP 997,540.31 and Deposit for 1 month997,540.31 x .03 x 30/365 = 2,459.69 = 1,000,000 in total at T30Cost of Borrowing: 997,540.31 x .0425 x 60/365 = 6969.12Total to Repay at 60 days = 1,004,509.43Effective Cost of Borrowing = 4,509.43 x 365/30 = 5.4865 from T30-T60

1,000,000


Financial FuturesDefinition

• A term used to designate the standardised contracts covering the purchase or sale of an agricultural commodity e.g. corn, commodity e.g. oil, foreign currency or financial instrument for future delivery on an organised futures exchange

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Financial FuturesAn Example

Three Month Eurodollar Interest Rate Future

Unit of Trading USD 1,000,000

Delivery/Expiry Months March, June, September, December and four serial months, such that 24 delivery months are available for trading, with the nearest six delivery months being consecutive calendar months

Delivery /Expiry Day First business day after last trading day

Last Trading Day 11.00 Two business days prior to third Wednesday of delivery month

Quotation 100.00 minus rate of interest

Minimum Price Movement (tick size & value)

0.01

(USD 25)

Initial Margin

(Straddle Margin)

USD 625

(USD 200)

Trading hours 08.30 – 16.00


Financial FuturesExample

• Date: 21st October 2009• Situation: USD 1,000,000 due November 21st 2009• Intention: Invest three month on interbank market• Problem: Expect rates to fall from current rate of 2 %

Questions

1) Will you buy or sell futures?

2) How many?



Action Today

Today in the Futures Market:

Buy one December contract at 98.1

(100 -1.9%)

Note: at today’s rate of 2 % USD 1,000,000 would earn

1,000,000 x .02 x 90/360 = 5,000



Action on 21st November

• In cash market, arrange three month deposit of USD at current rate of 1.5 %

• 1,000,000 x .015 x 90/360 = 3,750

• This equals a ‘loss’ of 1,250 over 2% rate

• Sell the future for 98.6 (100 -1.4)



Net Result

• 1,000,000 x .015 x 90/360 = 3,750

• Bought Future at 98.10

• Sold Future at 98.60

• Gain 50 basis points

• At USD 25 per ‘tick’ =1,250

• = 5,000



Question?• Why have we managed a perfect hedge?

i.e. ended up with USD 1,005,000 at end of

deposit?• Note: the cash price moved from 2 to 1.5• A movement of 50 basis points• The futures price also moved by 50 basis points

exactly offsetting the loss on the cash market



• Will this always be so?

• No

Cash market

Futures market

TodayExpiry

Basis



• So what if held to expiry?• Cash market = 1.5 therefore futures price would be

98.50• But bought at 98.10• Gain 40 basis points• Therefore net result = 40 x 25 = 1,000• Plus interest earned at 1.5 = 3,750• Total 4,750• So effective interest • = 4,750/1,000,000 x 360/90 x 100 = 1.9%


Forward Rate Agreements (FRA’s)

An agreement between two parties to compensate one another, in cash, on a certain date for the effect of any subsequent movement in market rates in respect of a future interest period.


FRA ExampleNeed to borrow GBP 1,000,000 in 30 days time for 30 days. Worried rates will rise.

Rate Agreed 51/8 (5.125)Actual Rate On Day T30 51/4

Compensation amount paid by Bank to Company1,000,000 x .05125 x 30/365 = 4,212.331,000,000 x .0525 x 30/365 = 4,315.07

= 102.74

= 102.74 = 102.30 1 + (.0525 x 30/365)

Quote Period Rate

1-2 5-51/8

1-4 51/8-51/4

3-12 51/4-53/8


Test

1,000,000, - 102.30 = 999,897.70

999,897.70 x .0525 x30/365 = 4,314.63

Less Compensation Amount = 102.30

Total Net Interest Paid 4,212.33


Interest Rate SwapComparative Advantage

Fixed Floating

AAA 8 Libor + 1/4

BBB 10 Libor + 1/2

Difference 2 1/4

Benefit 13/4


81/2

L

-(L + ½)

+(L)

-81/2

Net –9.0

AAA

-(8)

+ 8.1/2

-L

Net – (L –1/2)Benefit

¾ + 1

13/4

BBB81/2

L

-(L + ½)

+(L)

-81/2

Net –9.0


Interest Rate Swap

AAA

-(8)

+ 8.51/2

-L

Net – (L –1/2) 1/4

¾ ¾

13/4 Benefit

Bank81/2

L

-(L + ½)

+(L)

-83/4

–91/4

BBB

L

83/4

+ 1/4


Interest Rate Cap or Ceiling Agreement

An interest rate cap is an agreement between the seller or provider of the cap and the borrower to limit the borrower’s floating interest rate to a specified level for an agreed period of time. For the investor substitute floor and investor above.


Interest Rate Cap

Unhedged Rate

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0 1 2 3 4 5 6 7 8 9Market Interest

Rate

Hedged Rate

Eff

ectiv

e In

tere

st R

ate

Cap: 5 Years, 6 Mo Rollover, Strike Price 7%, Premium 225 per million


Interest Rate Collar Agreements

An interest rate collar is an agreement whereby the seller or provider of the collar agrees to limit the borrower/investors floating interest rate to a band limited by a specified ceiling rate and floor rate.


Interest Rate Collar

Unhedged Rate

0

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5

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8

9

10

Unhedged Rate

Hedged Rate

Collar: 5 year, 6 Mo Rollover, Zero Premium, Strike Prices 7% and 3%


Duration

You have a bond, life 5 years with annual interest payments of 8%, face value GBP 1,000

What is your problem?

• Market Price Risk

• Re-Investment Rate Risk


DurationDuration gives an ‘average life’ of the cash flows of an instrument by weighting the Net Present Values of the cash flows by their timing.

Cash Flow Year NPV NPV x Y

80 1 74.07 74.07

80 2 68.59 137.18

80 3 63.51 190.53

80 4 58.80 235.20

1080 5 735.03 3675.15

1,000 4,312.13


Duration

Duration = 4,312.13 = 4.31 years

1,000

Known as Macauley Duration


Uses of Duration

Immunisation

Wish to fix yield on a portfolio of bonds regardless of whether interest rates go up or down.

Done by creating a portfolio of bonds with a Duration equal to the required period.


Uses of Duration

Price Sensitivity

Modified Duration which is Macauley Duration

(1 + y/n)

Where y = yield

n = number of discounting periods

4.31 = 3.99

(1.08)

Or increase in the market interest rate of 1% will lead to a drop in the value of the bond of approximately 3.99%.

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Copyright anbirts1 MSc In General Management FX and Interest Rate Risk Management